Is BitCoin A Bubble?

With the astronomic rise of Bitcoin’s dollar value in recent months, the question everybody has is whether it’s a “bubble” or not.

The simple answer to this is “yes”… however, understanding why is vital. This tutorial is going to explain how and why an economic bubble forms, what causes them to burst and ultimately how we can use this data to determine whether Bitcoin falls into this category.

Firstly, I must stipulate that this is not financial advice, nor is it an opinion on a publicly traded asset. The information and assertions described in this article are for educational and informational purposes only…

Bubbles

The idea of an economic “bubble” has been with us for almost half a millennium now.

The earliest recorded “bubble” was in the form of the now-famous “Tulip” bubble of the 1630’s, where a price of certain Dutch tulip bulbs skyrocketed on the premise that there was massive demand amongst the upper classes. You can learn more on the Quora.Com Website: answers to crypto. This speculation was – of course – unfounded, and what ensued was a boom-and-bust type effect, where many lower income individuals lost “everything” as the price of Tulip bulbs dropped dramatically (wiping out their “investment”).

Whilst the Tulip episode is often cited as “the” bubble, there have been many others including most recently the “.com bubble” (where speculation on “Internet” companies lead many to put money into woefully overambitious projects).

Unfortunately, a clear definition of a “bubble” is difficult, as there are so many variables which can contribute to price fluctuations. What’s generally accepted in the financial world is that a “bubble” is a speculation-driven increase in the *price* of a commodity, which far and away outstrips its intrinsic value.

To give you a brief synopsis (and you may be well to touch on Marx and Adam Smith’s “Wealth of Nations” here), the “value” of a product lies in its value to the end user.

This value can come in a number of forms, which are typically denoted by which form of capital they are best able to increase for the buyer (social/financial/health). Whilst Smith generally referred to “value” as being directly related to the use it provided someone, Marx saw it from the perspective of how much energy was invested into it by the producer.

The point is that the “value” of a product differs from person to person. The idea that a product is only worth as much as its manufacturing quality etc is incorrect… it’s worth what people are willing to pay.

It’s this ambiguity in the true value of a product which has often lead to the “bubble” effect…

Speculation

At the core of ALL bubbles lies speculation.

Speculation is the process of buying something cheap in the anticipation that its value (price) rising significantly, either due to some external event or a change in the market.

The art of speculation has existed forever, and lies at the core of many investing fundamentals (it’s often described as taking a “risk”). The problem with bubbles is not with speculation itself, but is best evidenced by speculation.

You see, the way in which a “bubble” forms is that a pseudo market is created for a particular commodity. This pseudo market often gives the impression that a commodity has a higher value than it actually does, drawing the attention of other people who also want to capitalize on its “new demand”.

These new markets are typically predicated on the idea that the commodity/asset in question is very quickly going to have “mass adoption”, leading to “ordinary” people wanting to buy one. This is what drives the price up – as most of the speculators consider the potential rewards “too big to miss out on”, leading the price of the asset to increase.

Whilst somewhat logical, the reality is different. The problem is that most people who have never experienced a bubble, or even aggressive speculatory tactics are often oblivious to the scale of misinformation that can be spread to get you to buy a particular product. This is the core of whether you should be treating “Bitcoin” as a bubble or not.

The following tutorial is going to examine the level at which Bitcoin is likely a bubble, and what it’s going to be doing in the future.

BitCoin

Emerging in 2009 off the back of the technology it’s built around (Blockchain), Bitcoin has raised in price inexorably over the past few months. The price of the asset – at least to me – is nowhere near its intrinsic value, and as such I always explain that anyone “trading” Bitcoin is merely indulging in speculation, not actual investing. I’ll explain about this in a second.

The underpin of “Bitcoin” technology is that it’s meant to be a decentralized currency that can never be regulated by banks/governments, thus making it much more “secure” and “safe” than the currencies of some of the world’s most vulnerable economies.

Whilst lost on many people in the West, hyperinflation, corruption and war often undervalue a currency, leaving the “everyman” to pick up the tab for a government’s folly.

To combat this, people used to turn to keeping physical assets (livestock/precious gems) as a way to ensure the stability of their wealth. With Gold being the most common representation of this ideal, it’s no surprise that many have begun turning to “bitcoin” to fulfil the same ideal.

This ledger is completely encrypted and is unable to be tampered with by governments etc.

It basically means that you can “pay” for products/services anywhere in the world without the knowledge of the governing body of that local area. Whilst the criminal connotations to this are obvious, what isn’t is the ability for money to be sent cross borders or even used to fund different projects without the necessity of government approval.

The point here is that the core ideal of Bitcoin does have value. The premise that you could exchange $15,000 for Bitcoins in the US, send the Bitcoin to China where a factory owner could deposit it for their own currency is actually very appealing (anyone who’s tried to transact money internationally will likely agree). The problem lies in how this achieved.

The problem with BitCoin is precious few actually understand how it works, and even fewer are actually able to translate this into an actual price for the commodity. Being able to do this is ESSENTIAL in understanding whether it’s a bubble or not…

BlockChain

The best way to determine an underlying price for Bitcoin is to determine who is eventually going to pay for the service. Whilst some companies, such as Google and Facebook took some time to reach profitability, you could at least see how they were able to create revenue. They had a business model.

The problem is that Bitcoin is built on a new technology called “Blockchain”, which is basically a decentralized database. Therefore, the real value of Bitcoin lies in the adoption & use of the Blockchain technology it so espouses… so what is it?

Blockchain is the web’s answer to data versioning.

Whereas today we have files and database entries, there is no way to keep track of the versions of this data. If you update a file, or change a database record, it’s changed – not updated. As such, one of the biggest issues for people – especially in the creative world – has been keeping track of the most recent versions of files, data and database entries.

The idea of “blockchain” was introduced to split data into something called “blocks”. Whilst files etc are still used, their current version is represented by a “block”. The block is part of a “chain” which updates each time you wish to save new versions of the files inside that particular chain. The chain may have a large number of files/folders inside, or just a set of data.

Now, the point here is that whenever you “save” data, with Blockchain, you’re not actually “saving” it but creating a new “block” on the chain. This means that you’re able to “traverse” the various blocks to bring back the different versions of the data you may have saved.

Think of it like a telephone directory which constantly keeps its numbers up to date – with each number representing a “block” in the chain. This is all well and good, but ultimately the key is to consider that part of the “blockchain” ideal is to have a decentralized data structure – allowing each chain to be updated from millions of potential servers. This decentralization makes the system especially suited to financial transactions.

The cryptocurrency idea was sparked from the idea that you could encrypt certain blockchains with particular encryption hash algorithms. These algorithms would only allow you to store certain data, for individuals who had the correct encryption keys. The different crypto coins all represent different algorithms.

Conclusion

My own personal opinion is that the current setup is definitely suggestive of a bubble.

Not only is the price of “Bitcoin” determined by a woefully under-regulated secondary market, but the majority of the “gains” from a Bitcoin “investment” are based solely on the price another trader is willing to pay. In other words, the economics don’t add up… AT ALL.

The trick to determining a solid investment is to understand how much return over the lifetime of the asset you will be able to realize. An asset should provide yearly returns, which are split amongst the investors who all own a stake. For example, with companies, these come in the form of dividends determined by equity stakes.

The price of certain assets can be calculated relatively simply, depending on the level of returns it’s been seeing and seeing how they’re looking to build out that asset in the future (this is where speculation comes in). The problem is that Bitcoin has no such basis for returns. The use of the technology is devoid of financial transaction, and thus the “everyman” won’t be paying a penny to use it.

The current money for Bitcoin seems to be coming from the many exchanges who have set up (some of which have collapsed in spectacular fashion).